Markel Corp (MKL) Analysis by Find - Me - Value

Markel Corp.
(MKL)
June 2017
@find_me_value
Twitter: @find_me_value Email: findmevalue@gmail.com

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Brief Overview of Markel Corp.

Summary:
Insurance company specialty insurance, niche markets
Focus on differentiation through expertise of clients, services
Formed in 1930 in Virginia, December 1986 IPO on NASDAQ at $8.33/share
Currently about $975 per share (BVPS is $615, trading at ~1.6x BVPS)
Compounded stock price about 17% CAGR since IPO in 1986
Models the business to be like Berkshire Hathaway
Consistently have underwriting profits
Invest the insurance portfolio in a double-barreled approach of public and private equities
Diversify the overall business through non-insurance company ownership
Grow earnings power at above-market rate
Measuring progress on longer term basis
Not splitting the stock price as it creates no economic value
No dividend, reinvests all cash flow

Important Events for Markel

Major Event: Terra Nova Acquisition (1999)
Markel wanted to expand more internationally
Acquired Terra Nova for $879 million, split about 50% in stock and 50% in cash
Subsequently had terrible underwriting performance as Terra Nova did not underwrite
policies appropriately
2000: 114% combined ratio
2001: 124% combined ratio
2002: 103.4% combined ratio
Example: 2000 Annual Report (7 months after acquisition was made)
The underwriting results of our International operation were disappointing, as we had a combined ratio of
116% from continuing operations. This is approximately 6% worse than our original expectation. These
poor results were due to business that was on the books prior to our acquisition. Throughout the year we
repriced and re-underwrote the ongoing business, and eliminated many underperforming programs. As a
result, we expect to report improved results in 2001, and we continue to believe that we will be able to
achieve underwriting profitability in the not too distant future.
The issues with the Terra Nova acquisition, in my opinion, is what caused tremendous
shareholder uncertainty with the late 2012 announcement of the Alterra Capital
acquisition, which would expand Markel into reinsurance

Major Event: Alterra Capital Acquisition (2013)
Announced December 2012
The $3.13 billion deal would be 73% in stock and 27% in cash
Stock price fell from $486 to $436 on the day of the announcement, a ~10% decline
Shareholders likely remembered the Terra Nova acquisition, the desire to enter into new
markets through M&A, and the subsequent terrible underwriting discoveries that led to a
few years of underwriting losses
Did Markel have underwriting losses post-Alterra, similar to Terra Nova?
2013: adjusted combined ratio of 101.8% for the reinsurance segment
2014: 95.7% combined ratio for reinsurance
Looks like Markel management avoided making the same mistake twice

Why did Markel Acquire Alterra?
Increased scale and size, almost doubling their gross premiums written to $4.4 billion
from $2.5 billion
Some insurance duration diversification about 50% would be short-tail, 50% long-tail
Alterra was 56% short-tail, 44% long tail
Markel believed Alterras management did an adequate job reserving their policies written
Expands the investment balance sheet, giving Gayner (Markels CIO) a total of $16 billion
to work with
Adjust the Alterra portfolio to become more Markel-oriented
End of 2012, 94.9% of the portfolio was in cash and fixed maturities, 5.1% in hedge funds

Overview of Insurance

Markels Insurance Business:
Largely a specialty insurance provider
Different than standard market rates more regulated, products and coverage is mostly
uniform
Standard market is highly competitive on price
Specialty market (where Markel writes insurance) is less price-sensitive, more focus is on
hard-to-place risks that are outside of expertise of standard insurance carriers
Some niche markets Markel focuses on:
Wind and earthquake exposed commercial properties
Professional liability
Workers compensation for small businesses
Classic cars
Summer camps

What Kind of Insurance Company is Markel?
$3.9 billion in earned premiums in 2016 (similar in 2014, 2015)
Earned Premiums = 78% is non-reinsurance
Reserves = 74% are non-reinsurance
About 60% of business is casualty / 40% is property
80% of premiums written are in North America (77% United States), with 7% from UK

Insurance Overview: Underwriting is a Strength
Have shown a good job of adequately
reserving losses, compared to actual claims
paid (see chart)
Focus on underwriting profits is a true
differentiator in the insurance industry; other
companies will say this, but it is lip service
However, this also means that MKL will not
grow premiums much, if at all, at times during
price-competitive times
This focus on underwriting profits limits their
ability to extract leverage out of the fixed
income portfolio; however, it allows them to
invest a higher percentage of SH Equity in
investments than the typical insurance
company

Underwriting: Compared to P&C Industry
If combined ratio > 100%, they lose money

on underwriting insurance for the year

Markel Consistently Outperforms P&C Industry on Underwriting

How Insurance Has Impacted Markels Economics
The market has been soft for the last ~12
years or so; in other words, excess capital and
too much competition on price leads to often
underpricing risks and later losing money
Markels float slowed down in mid-2000s,
which is when the soft market began
Organic growth in the insurance business (i.e.
writing policies) slowed, as since Markel tries
to match the reserves (duration and in size)
with a fixed income portfolio, the fixed income-
to-S/H Equity leverage declined
Due to this, Markel shifted focus to earning
money in other ways in addition to U/W profits

Writing Insurance & the Fixed Income Portfolio
The fixed income portfolio, all things being considered,
grows with growth in the reserves/ underwriting more
insurance
Shorter-tail: more investments likely will be shorter
duration, more liquid, as premiums in and claims paid
have short lives. This is more common in property-type
insurance.
Longer tail: possible to expand the fixed income portfolio
a little more than claims take longer to pay out. This is
more common in casualty-type insurance.
As Markels insurance business mix has shifted, they
are now more matched in terms of insurance reserves
with their fixed income portfolio
Due to the fact that the duration of the liabilities are 4-6
years, they underwrite consistently at a profit, and earn
about $300m post-tax in net investment income, they
can invested a sizable portion of SH Equity in higher
return investments (public equities)

Soft Market in Insurance since 2005
Fixed income leverage tied directly to growth
in insurance business
As the market became soft, Markels reserve
(and float) became stagnant, actually
declining some
Other components of the balance sheet were
growing still namely the equity portfolio
Goals is to match insurance liabilities with the
fixed income portfolio and use the
shareholders equity for higher return
investments, such as Markel Ventures and
Equities
Markel strives to be around 65% of SH Equity
in Equity Investments (see chart)

Soft Market = Stagnant Premium Growth:
See chart right
The soft market made writing insurance less
profitable, Markel slowed down writing insurance,
the fixed income portfolio became stagnant while
SH Equity continued to grow. Thus, the Fixed
income-to-SH Equity leverage decreased
In 2002, fixed income was 2.8x the size of SH
Equity. A 3% yield on the fixed income portfolio
essentially grew BV by 8.4%, prior to any other
income sources.
Its not difficult to see why Markel grew BVPS
around 20% CAGR in the early 2000s
Now, fixed income-SH Equity leverage is 1.17x.
The same 3% yield adds about 3.6% growth in BV.

BVPS Growth

BVPS Metric
Does BVPS growth the only metric that matters?
In my opinion, for the most part, yes
Similar to Berkshire Hathaway. Despite the tremendous non-insurance segments at BRK,
what propels stock returns is adequate growth in BVPS at this point.
Of the total assets, $25 billion are in insurance operations and $1.5 billion in Markel
Ventures. Given that Ventures earns minimal net income and only comprises of 5-6% of
assets, Markel is still very much an insurance company and is valued based on B/S
returns.
It is my belief that BVPS growth is the primary metric for the stock.
Investors may, at times, recognize the value of MKL Ventures, but the backstop for
valuation will continue to be BVPS growth over time, until Ventures becomes far more
sizable and contributes more to net income/FCFE

Markel: BVPS & Growth
BVPS Growth has been impressive over time, growing at a ~14% CAGR from 1999-2016
Markels stated goal is to double BVPS every 5 years
In the following slides, I will discuss exactly how Markels BVPS growth has been so strong
Using history as a guide, I will then try to estimate how Markels BVPS growth should be going forward

What Is the Narrative for Why BVPS Grows?
Many think of Markel as growing BVPS at above-industry rates for these reasons:
Culture for writing insurance; i.e. actually trying to have underwriting profits
Investing in equities at an above-industry rate (50-65% of SH Equity is in equities)
Above average investment skill by Gayner, the CIO
Double-barrel approach of investing capital: public market equities or private market (Markel Ventures)
I briefly discussed Markels skill as underwriters of insurance
This does provide them the luxury of investing in equities at a higher percentage of SH Equity than other
P&C companies
Provides them the luxury to invest in private companies Markel Ventures due to the relative consistency
in underwriting, among other things
Is Tom Gayner, Markels CIO, the secret sauce for their investing capabilities?
Does Markel Ventures propel book-value-per-share growth in addition to their other
methods?

Historical BV Growth:
Based on my analysis, since
E2002, S/H Equity has grown
by $7.3 billion:
$2.3 billion from Alterra
acquisition in 2013
$3.7 billion from net income
$1.4 billion from OCI flowing
through to the balance sheet, net
of taxes
Some reduction/increase from
share repurchases, RSUs, stock
issuance
Excluding Alterra, 100% of the
BV growth has come from net
income and OCI
73% from net income
27% from OCI gains

Is Tom Gayner Markels Lou Simpson (GEICO)?
Gayner does not do any of the underwriting business, therefore any underwriting profit is
not his doing
Gayners primary responsibilities are:
Invest the public equity portfolio
Invest the fixed income portfolio
Invest in Markel Ventures (private companies)
It is undeniable that the investment portfolio has been the main reason for historically
strong BVPS growth. Is it due to:
Actual investment performance being above average
Investment leverage
Large portion of SH Equity invested in equities, in order to drive higher BVPS growth
Answer: All of the above.
However, I believe the investment leverage and the decision to have a sizable portion of
SH Equity in public equities are the dominant force behind the growth

Investment Performance: Public Equities
In comparing the equity portfolio performance with the S&P 500, a substantial portion of alpha was generated prior to the global
financial crisis of 2008/2009
Gayner purposefully decided against investing in many technology stocks in the late 2000s, and he did superior to the S&P 500
due to this in the following year of the early 2000s
From 2009 to 2016, the average outperformance by Gayner in the public equity portfolio has been 1.7% per year
1.7% may seem immaterial, but I consider it a nice accomplishment, especially considering the increased competitiveness of
public market investing and as Markels balance sheet has expanded, thus limiting the potential public investments that can be
made
By my calculations, Gayner has added around $300m (pre-tax) in added returns from 2009-2016, compared to if he just
invested passively in the S&P 500

Investment Performance: Fixed Income
Comparing the fixed income portfolio to the Barclays Aggregate Bond Index, despite the volatility in comparing the two on a year
to year basis, there really hasnt been any net outperformance on a pre-tax basis
However, Markel invests a sizable portion in municipal bonds, some are tax free and some are not
On a net basis, about 1/3 of the post-tax net investment income, which is the single largest driver of BVPS growth, comes from
tax-free municipal bond income
Municipal bond tax-free interest = ~$90 million per year
Being active in choosing which bonds to own is more apparent in looking at the estimated post-tax bond returns

Markel Ventures
The creation of this segment inside Markel likely has more stock price value than actual economic value, at
this point
If we prefer to value MKL on a BVPS growth basis, Ventures barely contributes:
$1.2 billion in revenues in 2016
$165 million in EBITDA (which would have been 2.1% of beginning of the year MKL S/H Equity)
With depreciation and amortization expenses of $60 million + $35 million in interest expense, not much net income from Markel Ventures yet
$56 million of net income
The amortization expenses are due to the acquisitions, in due time should decrease and the FCFE should mirror net income more closely
The economics of Markel Venture are decent, and net income understates the actual cash flow the business is
generating
Net income of $56 million in 2016
FCFE of $75m - $80m in 2016
I would anticipate Markel Ventures will become a meaningful contributor at some point; but currently:
Markel Ventures is likely worth around the invested capital in the business
The actual cash flow exceeds net income, but is not meaningful enough yet to move the stock
As there is limited net income, it does not propel BVPS growth yet, which I still believe is the primary metric for the stock price
However, if there is continued reinvestment in Ventures, it will undoubtedly give investors more to think about beyond just BVPS growth as the
economics of Ventures is understated in its contribution to BV

Overview of Markel Ventures Economics:

Circling Back Around to BVPS Growth
Why else is BVPS growth the primary current metric for valuing Markel Corp?
Their entire philosophy is: Our overriding perspective is a long-term one, and
correspondingly, we believe growth in book value per share over a multi-year
period is the best measure for assessing how we are doing at running the Company
and creating shareholder value.
Compensation is also tied to BVPS growth: For 2016, all of our executive officers
received incentive compensation relative to their base salaries on an equivalent
basis, and incentive compensation should comprise the vast majority of their target
compensation. Consistent with our long-term perspective, we believe incentive
compensation should be paid primarily on the basis of growth in book value
over a multi-year period.
The principal performance metrics for any compensation is book value growth over
the past 5 years
It would make sense that if BVPS growth is the primary metric for management
compensation, as well as it being their core management philosophy, at current state
BVPS growth should also be the primary metric for valuation
Despite Markel Ventures revenues and robust EBITDA, management is not incentive
based on MKL Ventures at the moment, as minimal net income from Ventures flows
through to BVPS growth

What Has Been Historical Drivers of BVPS Growth?
My analysis is that 73% of BV growth has come from net income, 27% from OCI
Of the net income, here are the dominant contributors:
Net Investment Income (3x as much of a contributor compared to U/W profits)
Underwriting Profits
Markel Ventures (< 1% run rate in 2017 as a contributor to BVPS growth)
Offset by interest expense amortization charges
Of the OCI, the dominant contributor is unrealized gains in the investment portfolio, largely the
equities, net of estimated taxes
Flow through of the realized selling in the investment portfolio, which increases net income on the P&L, but decreases the
unrealized gains in OCI if there is a net realized gain

Net Income: Largest Driver of BVPS Growth
73% of the BV growth due to net income
Despite being known for their underwriting skill, the
vast majority of the BVPS growth was due to the
interest income and dividends received from the
investment portfolio
This chart may be very telling in terms of
understanding why BV growth has slowed over the
last 15 years
Investment portfolio leverage to SH Equity has declined
And thus, NII contribution to BV growth for that year has
decline
From 2002-2007, Net Investment Income (interest
income + dividends from equities) contributed 10-
13% per year. In other words, if they didnt earn any
return on anything else, they wouldve increased BV
by 10-13% CAGR during that time period.
Now, it adds incremental BV contribution of less
than 4%, which is about 1/3 of what it was 15 years
ago.

What Drives Net Income?
The largest contributor to BVPS growth is net investment income
About $400m pre-tax, per year, around $300m post-tax (estimated)
Historical BVPS growth was much higher due specifically to the fixed income leverage-to- SH Equity, not as much the Equity
portfolio
As investment leverage has declined, BVPS growth has come down
Net Investment Income, a function of:

Fixed income yields and reinvestment yields
Equity yields and amount in equities
Taxation - how much is in tax-free municipal versus the 35% corporate tax on dividends, interest
Current issues are:

Fixed income yields have been coming down, as bonds mature and current rates are low
Premiums are not growing organically, and thus the fixed income leverage to SH Equity has been coming down from previous years
More and more of the growth in BVPS is coming from OCI, which is tied directly to the performance of the equity portfolio (stock
market)
What happens if the stock market takes a tumble, how does this impact BVPS growth?
Current valuations in the public and private markets are elevated, and thus there is less activity in MKL Ventures (except for a few
deals here and there) and the public equity portfolio is under-invested, at 0.55x (+/-) compared to the goal of 0.65x
In order to grow BVPS at double digit clips in this environment, would need to use the excess cash on the balance sheet + current
MKL stock to make another acquisition (I think this is an actual possibility, based on their desire to grow BVPS and lack of
investment opportunities)

Thinking About Future BVPS Growth:
To think about future BV growth, may be helpful to think of different scenarios and how net income
will be influenced
If interest rates higher, MKL has about $4 billion in ST investments and cash (unrestricted) earning about $10 million a year
on (0.25% ROR), and they would be more inclined to put the capital to work. Currently, with rates low, they are purposely
being more patient and feel the opportunity cost is minimal
If they write more casualty insurance: fixed income to SH Equity leverage could increase, as casualty is more long-tailed
If they write more property insurance: fixed income to SH equity leverage could decrease, as it is more short-tailed. Also -
could decrease the duration of the fixed income portfolio (meaning lower yields on portfolio). This would make the balance
sheet more volatile.
At current scenario, they are earning about $275m - $300m post-tax from interest and dividends. Considering the lack of
reinvestment options in fixed income markets, the lack of insurance organic growth, the higher valuation in both public and
private equity markets, the cash flow likely to accumulate in ST investments and cash for the time being. This is good (they
are being patient, are disciplined) and bad (temporarily under-earning, market could stay this way for some time, in which
they are under-earnings and continuing to accumulate cash. Maybe this leads them to become impatient?)

Estimating Current BVPS Growth:
Assumptions:
No large M&A deal
Current soft insurance market
Minimal core premium growth
Increased focus on underwriting profits due to other circumstances requiring the need of more contribution of U/W profits
Some growth in MKL Ventures
Fixed income leverage-to-SH stays around 1.2x, but declines some over time due to anemic premium growth
Minimal realized gains on investment portfolio as equity dividend yield (at cost) is about 3.2%, but ~25% of the stocks they own
do not pay dividends. The remaining 75% of stock portfolio averages 4% dividend yield. This implies theyve been held for a
period of years, as only 5 of their top 50 holdings has a dividend yield > 3.0%
Net Investment income = easiest to forecast
Underwriting profits = forecastable, in a range, barring any large CAT event
The largest problem I foresee is that there are limited reinvestment opportunities, currently
Limited reinvestment back in to equities
Limited desire to add much to the fixed income portfolio, as rates are low and premium growth is low
Valuations in the private business market is higher, as theyve been outbid as others are willing to pay higher valuations

BVPS in Current Market State: Assumptions

BVPS Growth Estimates:

Notes on BVPS Growth:
Equity portfolio is under-leveraged. If go from 58% of SH Equity to 65%, would increase the equity portfolio by $585 million. If
average dividend is 1.5% and returns are 6%, it would add an extra $2.00 - $2.50 per share in BV (extra 3% +/- on current BV)
If insurance market became hard, returns could increase substantially, despite the likelihood that there would be an initial BV
impact from whatever event ( large CAT, for example)
Interest rates rising would likely be a net benefit, as bond income could be reinvested, and at better yields, and there is an extra
$3 - $4 billion in dry powder just waiting. If $3 billion were reinvested at 3% pre-tax yields, it could add about $5 per share in BV
due to increases in net investment income without assuming any unrealized gains
If the market stays as it is, I would guess that Markel grows BVPS at around 5-8% over the next 3-5 years
Could be higher if underwriting is slightly better. For every 1% improvement in total combined ratio, would increase BVPS by $1.75 +/-
Markel Ventures could improve at a faster organic clip than 5%
Investments could perform better than 6% for equities and 0% for fixed income
If there is minimal unrealized growth in the portfolio, based on the current state of the market and industry, I would estimate
about 4% BVPS growth
My guess: if the market stays AS IT IS Markel will do a decent size acquisition in the next 2-3 years. Could be in the
insurance space, or a larger acquisition to bolster Markel Ventures. This would (obviously) increase BVPS growth and
provide other reinvestment opportunities.

Feedback/Comments are Appreciated.
Twitter:
@find_me_value

Markel Corp (MKL) Analysis by Find - Me - Value

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If combined ratio > 100%, they lose money

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Net Investment Income, a function of:

Current issues are:

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